Why is there a Difference in Earnings?

In the United States today, a physician earns about $200,000 a year, a police officer about $50,000 and a farm worker about $20,000. These examples illustrate the large difference in earnings that are so common in our economy. The differences explain why some people live in mansions, ride in limousines and vacation in exotic places, while other people live in small apartments, ride a bus, and vacation in their own backyards.

Wages are governed by labour supply and labour demand. Labour demand, in turn, reflects the marginal productivity of labour. In equilibrium each worker is paid the value of his or her marginal contribution to the economy’s production of goods and services.

This theory of the labour market, though widely accepted by economists, is only the beginning of the story. To understand the wide variation in earnings that I observe, one must go beyond this general framework and examine more precisely what determines the supply and demand for different types of labour.

Workers differ from one another in many ways. Jobs also have differing characteristics – both in terms of the wage they pay and in terms of their non-monetary attributes. I consider how the characteristics of jobs and workers affect labour supply, labour demand, and equilibrium wages.

When a worker is deciding whether to take a job, the wage is only one of many job attributes that the worker takes into account. Some jobs are easy, fun and safe; others are hard, dull, and dangerous. The better the job as gauged by these non-monetary characteristics, there are more people who are willing to do the job at any given wage. In other words, the supply of labour for easy, fun and safe jobs is greater than the supply of labour for hard, dull, and dangerous jobs. As a result “good” jobs will tend to have lower equilibrium wages than “bad” jobs.

For example, imagine you are looking for a summer job in a local beach community. Two kinds of jobs are available. You can take a job as a beach-badge checker, or you can take a job as a garbage collector. The beach-badge checkers take leisurely strolls along the beach during the day and check to make sure the tourists have bought the required beach permits. The garbage collectors wake up before dawn to drive dirty, noisy trucks around town to pick up garbage. Most people would prefer the beach job if the wages were the same. To induce people to become garbage collectors, the town has to offer higher wages to garbage collectors than to beach-badge checkers.

Economists use the term compensating differential to refer to a difference in wages that arises from non monetary characteristics of different jobs. Compensation differential is prevalent in the economy. Here are some examples.

Coal miners are paid more than other workers with similar levels of education. Their higher wage compensates them for the dirty and dangerous nature of coal mining, as well as the long term health problems that coal miners experience.

Workers who work the night shift at factories are paid more than similar workers who work the day shift. The higher wage compensates them for having to work at night and sleep during the day, a lifestyle that most people find undesirable.

Professors earn less than lawyers and doctors, who have similar amounts of education. Professors’ lower wages compensates them for the great intellectual and personal satisfaction that their jobs offer.

Human capital:

The word capital usually refers to the economy’s stock of equipment and structures. The capital stock includes the farmer’s tractor, the manufacturer’s factory and the teacher’s chalkboard. The essence of capital is that it is a factor of production that itself has been produced.

There is another type of capital that, while less tangible than physical capital, is just as important to the economy’s production. Human capital is the accumulation of investments in people. The most important type of human capital is education. Like all forms of capital, education represents an expenditure of resources at one point in time to raise productivity in the future. But unlike an investment in other forms of capital, an investment in education is tied to a specific person, and this linkage is what makes it human capital.

Not surprisingly workers with more human capital on an average earn more than those with less human capital. College graduates in the United States, for example, earn almost twice as much as those workers who end their education with a high school diploma. This large difference has been documented in many countries around the world. It tends to be even larger in less developed countries, where educated workers are in scarce supply.

It is easy to see why education raises wages from the perspective of supply and demand. Firms – the demanders of labour are willing to pay more for the highly educated because highly educated workers have higher marginal products. Workers, the suppliers of labour are willing to pay the cost of becoming educated only if there is a reward for doing so. In essence, the difference in wages between highly educated workers and less educated workers may be considered a compensating differential for the cost of becoming educated.